How The Markets Will React To A Government Shutdown

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September 30, 2013 10:48am NYSE:DIA NYSE:SPY

government shutdownDavid Zeiler: The markets are already nervous over a stubborn group of Republicans threatening a government shutdown unless Democrats agree to defund Obamacare, or at least delay implementation of the healthcare law another year.

“A government shutdown starting next week is looking increasingly likely,” Jim Russell, a regional investment director at U.S. Bank, told the Associated Press. “That will not be welcomed by the capital markets.”

The S&P 500 has slid 2% since Sept. 19 as Wall Street watches yet another budget-battle spectacle unfold in Washington.

The problem is that the federal government only has enough money to keep the government’s doors open through Sept. 30, the end of its fiscal year. Tea Party Republicans are using this deadline to try to defund the healthcare law.

So the House last week passed a “continuing resolution” to keep the government funded through December, but stripped out money for Obamacare. The Senate is expected to pass that same CR and send it back to the House – but with the Obamacare funding restored.

On Monday the House will have to decide whether to cave in and pass the Senate version or stick to their guns – and cause a government shutdown on Oct. 1.

“This is a sleeper issue right now, but it could really come to the fore,” Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ, told Bloomberg. “There is a risk of the stock market selling off a thousand points over two or three days.”

But even if the two parties in the House and the Senate somehow reach an agreement and engineer an escape from this self-made trap, the threat of a government shutdown will only be postponed a short time.

That’s because continuing resolutions only cover a few months, whether it’s mid-December (as in the House version) or mid-November (as in the Senate version). Then it’s right back to where we are now.

Then there’s the looming fight over the debt ceiling, which has even deeper implications for the markets because it also holds the threat of a default.

Congress is close to its limit on borrowing and needs to raise the debt ceiling by Oct. 17. Otherwise the federal government won’t be able to borrow any more money – a big problem when you borrow 40 cents of every dollar you spend.

The last debt ceiling fight in the spring and summer of 2011 also featured threats of a government shutdown, as well as a near-default that dinged the nation’s credit rating, which lopped about 15% off both the S&P 500 index and the Dow Jones Industrial Average.

Given the multiple threats of a government shutdown between now and the end of the year, investors need to make sure their portfolio is ready for whatever happens.

And strange as it may sound, it’s not all bad…

How the Markets Will React to a Government Shutdown

Before we get to what investors should do in the event of a government shutdown, we need to talk about what to expect.

Most markets will react negatively to an actual government shutdown, of course, though not all:

  • Stocks: Equities will go down. Most experts anticipate a drop of at least 5%.
  • Bonds: Interest rates will rise while yields fall. During the budget battles of 2011, yields on 10-year Treasury notes fell from 3.18% on July 1 to 2.61% on Aug. 2, eventually dropping to 1.88% by December.
  • U.S. Dollar: The U.S. currency will weaken if there’s a government shutdown, but could be in serious trouble if the U.S. fails to raise the debt ceiling and actually defaults.
  • Gold and Silver: Precious metals will rise as investors flee other investments for their favorite safe haven. The weaker dollar will also help push prices up.
  • Commodities: Most commodities, such as oil, will rise on a weaker dollar.

All that said, investors also need to understand that at some point Washington will resolve its fiscal issues, at least to the point where the government is funded and functioning.

And that’s where the opportunity arises…

Keep Emotions Out of the Equation

Title: Government shutdown - Description: how markets react to a government shutdown

As hard as it may be to stand by and watch the markets go crazy, investors need to keep their heads and resist joining the stampede.
As stocks head south, for example, be ready to buy or add to favorites that had gotten a bit too pricey.

Precious metals and other commodities, on the other hand, will give back their gains after the budget antics in Washington end. Savvy investors will hold off and buy on that dip, rather than buying during the surge.

Past experience shows this strategy could pay off nicely.

Back in 1995-1996, Republicans instigated a government shutdown in a budget battle with President Bill Clinton.

During the weeks of the government shutdown, the S&P 500 lost 3.7%. But in the month after it ended, the index rose 10.6%. Investors who bought in the midst of the crisis were rewarded with a very tidy 11% to 14% short-term gain.

Not too shabby.

And it’s a lesson well worth studying as the knuckleheads in Congress stumble and bumble their way to another government shutdown.

“Any market drawdown would be temporary in nature,” Chris Hyzy, who helps oversee about $325 billion as chief investment officer of U.S. Trust, told Bloomberg. “Sentiment is still skittish across the board. We’ve seen the Polaroid photo before; we’ve gotten ourselves through it in a much more difficult time than we are today.”

Related: SPDR S&P 500 ETF Trust (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA)

Money MorningWritten By David Zeiler From Money Morning

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